Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
Prepared by:
Dr. Jessica J. Frazier
and
Philip Li
Eastern Kentucky
University
CHAPTER 6
Reporting and Analyzing
Inventory
After reading Chapter 6, you should be able
to:
Explain the recording of purchases and
sales of inventory under a periodic
inventory system.
Explain how to determine cost of goods
sold under a periodic inventory system.
Describe the steps in determining
inventory quantities.
CHAPTER 6
Reporting and Analyzing
Inventory
After reading Chapter 6, you should be able to:
Identify the unique features of the income
statement for a merchandising company under
a periodic inventory system.
Explain the basis of accounting for inventories
and apply the inventory cost flow methods
under a periodic inventory system.
Explain the financial statement and tax effects
of each of the inventory cost flow assumptions.
CHAPTER 6
Reporting and Analyzing
Inventory
Explain the lower of cost or market basis
of accounting for inventories.
Compute and interpret the inventory
turnover ratio.
Describe the LIFO reserve and explain its
importance for comparing results of
different companies.
PURCHASES AND SALES OF
INVENTORY UNDER A PERIODIC
INVENTORY SYSTEM
Revenues from sale of merchandise
recorded when sales are made.
On date of sale, no attempt is made to
record the cost of the merchandise sold.
Recording Purchases of
Merchandise Under a Periodic
Inventory System
Purchases account is increased and
accounts payable increased when
merchandise is purchased.
Freight-in is increased and accounts
payable are increased or cash decreased
when buyer pays freight for merchandise
purchased.
Purchase Discounts
Purchase discounts, a contra account to
purchases, is increased and accounts
payable decreased when discounts are
earned.
Purchase Returns and
Allowances
Purchase returns and allowances, a contra
account to purchases, is increased and
accounts payable decreased when
merchandise is returned or an allowance
is given.
COST OF GOODS SOLD UNDER A
PERIODIC INVENTORY SYSTEM
To determine cost of goods sold:
Find balance in merchandise inventory at
beginning of period.
Add the amount of purchases of merchandise
inventory for the period to find cost of goods
available.
Subtract ending balance in merchandise
inventory to get find cost of goods sold.
The amount of the ending inventory must be
determined by a physical count.
DETERMINING INVENTORY
QUANTITIES
Determining inventory quantities involves
two steps:
Taking a physical inventory of goods on
hand.
Determining ownership of goods.
Taking a Physical Inventory
of Goods on Hand
Involves actually counting, weighing, or
measuring each individual of inventory on
hand.
Quantity of each kind of inventory is listed
on inventory summary sheets where unit
costs will be applied to the quantities to
determine total cost of the inventory.
Determining Ownership of
Goods
Goods in transit should be included in the
inventory of the company that has legal
title to the goods.
Consigned goods are counted in the
inventory of the owner rather than the
consignor.
Goods in Transit
FOB Shipping Point
Ownership of goods shipped FOB (free on
board) shipping point passes to the buyer
when the public carrier accepts the goods
from the seller. Therefore, goods should
be counted in inventory of buyer.
Goods in Transit
FOB Destination
Ownership of goods shipped FOB (free on
board) destination remains with the seller
until the goods reach the buyer and
should be included in the inventory of the
seller.
INCOME STATEMENT FOR A
MERCHANDISING COMPANY UNDER A
PERIODIC INVENTORY SYSTEM
Sales revenue
Cost of goods sold
Gross profit
Sales Revenue
The income statement for a
merchandising concern typically presents
gross sales revenues for the period and
deducts the contra revenue accounts
(sales returns and allowances and sales
discounts) to arrive at net sales.
Cost of Goods Sold
Cost of goods sold under periodic
inventory system will usually be more
detailed, starting with beginning
inventory, adding purchases, subtracting
ending inventory.
Goods Sold in Units
Beginning inventory
-0-
Purchases
1,250
Goods available
1,250
Ending inventory
Goods sold
250
1,000
Gross Profit
Cost of goods sold is deducted from net
sales to determine gross profit.
Gross profit is the merchandising profit of
the company.
ACCOUNTING FOR INVENTORIES
AND APPLY THE INVENTORY COST
FLOW METHODS
Determining ending inventory can be
complicated if the units on hand for a
specific item of inventory have been
purchased at different prices.
Inventory Costing Methods
There are a number of inventory costing
methods:
Specific identification is practical when a
company can positively identify which
particular units were sold and which are
still in ending inventory.
There is no accounting requirement that
the cost flow assumption be consistent
with the physical movement of the goods.
Cost Flows Assumptions
When items are indistinguishable from one
another, making it impossible or
impractical to track each item's cost, one
of the three cost flow assumptions may be
used:
First-in, First-out (FIFO) method
Last-in, First-out (LIFO) method
Average cost method
First-in, First-out (FIFO)
Method
First-in, First-out (FIFO) method assumes
that the earliest goods purchased are the
first to be sold.
Under FIFO, the cost of the ending
inventory is obtained by taking the unit
cost of the most recent purchase and
working backward until all units of
inventory have been costed.
Cost of Goods Sold - FIFO
Beginning inventory
Purchases:
6/2
6/8
6/25
Goods available
Ending inventory
Cost of goods sold
-0-
-0-
500@$100 $50,000
400@$125
50,000
300@$130
45,500
1,250 $145,500
250@$130
32,500
1,000 $113,000
Last-in, First-out (LIFO)
Method
Last-in, First-out (LIFO) method assumes
that the last goods purchased are the first
to be sold. LIFO seldom coincides with
the actual physical flow of inventory.
Under LIFO, the cost of the ending
inventory is obtained by taking the unit
cost the earliest goods available for sale
and working forward until all units of
inventory have been costed.
Cost of Goods Sold - LIFO
Beginning inventory
Purchases:
6/2
6/8
6/25
Goods available
Ending inventory
Cost of goods sold
-0-
-0-
500@$100 $50,000
400@$125
50,000
300@$130
45,500
1,250 $145,500
250@$100
25,000
1,000 $120,500
Average Cost Method
Average cost method assumes that the
goods available for sale are homogeneous
and allocates the cost of goods available
for sale on the basis of weighted average
unit cost incurred.
The weighted average unit cost is then
applied to the units on hand to determine
the cost of the ending inventory.
Cost of Goods Sold Average Cost
Beginning inventory
Purchases:
6/2
6/8
6/25
Goods available
-0-
-0-
500@$100 $50,000
400@$125
50,000
300@$130
45,500
1,250 $145,500
$145,500 / 1,250 = 116.4 per unit
Cost of Goods Sold Average Cost
Beginning inventory
-0-0Purchases:
6/2
500@$100 $50,000
6/8
400@$125
50,000
6/25
300@$130
45,500
Goods available
1,250 $145,500
Ending inventory
250@$114.6
29,100
Cost of goods sold
1,000 $116,400
FINANCIAL STATEMENT AND TAX
EFFECTS OF EACH OF THE INVENTORY
COST FLOW ASSUMPTIONS
The reasons companies adopt different
inventory cost flow methods are varied,
but usually involve on the three following
factors:
Income statement effects
Balance sheet effects
Tax Effects
Income Statement Effects
In periods of increasing prices, FIFO
reports the highest net income, LIFO the
lowest net income and average cost falls
in the middle.
In periods of decreasing prices, the
converse is true, FIFO will report the
lowest net income, LIFO the highest, with
average cost in the middle.
Balance Sheet Effects
In a period of inflation, the costs allocated
to ending inventory using FIFO will
approximate current costs.
Conversely, During a period of increasing
prices, the costs allocated the ending
inventory using LIFO will be significantly
understated.
Tax Effects
Both inventory on the balance sheet and
net income on the income statement are
higher when FIFO is used in a period of
inflation.
Many companies have switched to LIFO
because LIFO yields the lowest net
income and therefore, the lowest income
tax liability in a period of increasing
prices.
THE LOWER OF COST OR MARKET
BASIS OF ACCOUNTING FOR
INVENTORIES
When the value of inventory is lower than
its cost, the inventory is written down to
its market value by valuing the inventory
at the lower of cost or market (LCM) in
the period in which the price decline
occurs.
Lower of Cost or Market
(LCM)
Under the LCM basis, market is defined as
current replacement cost, not selling price.
For a merchandising company, market is the
cost of purchasing the same goods at the
present time from the usual suppliers in the
usual quantities.
The lower of cost or market basis may be
applied to individual items of inventory, major
categories of inventory, or total inventory.
COMPUTE AND INTERPRET THE
INVENTORY TURNOVER RATIO
Inventory turnover ratio is computed by
dividing cost of goods sold by average
inventory.
The ratio tells how many times the
inventory is turning over during the year.
Days in inventory, computed by dividing 365
days by the inventory turnover ratio, indicates
the average age of the inventory.
LIFO RESERVE AND ITS IMPORTANCE FOR
COMPARING RESULTS OF DIFFERENT
COMPANIES
Accounting standards require firms using LIFO
to report the amount by which inventory would
be increased (or on occasion decreased) if the
firm had instead been using FIFO.
This amount is referred to as the LIFO reserve.
Reporting the LIFO reserve enables analysts to
make adjustments to compare companies that
use different cost flow methods.
Chapter 6 Review
Know how to record purchases of inventory
under a periodic inventory system.
Know how to record sales of inventory under a
periodic inventory system.
Be able to calculate cost of goods sold and
ending inventory under a periodic inventory
system.
What are the steps in determining inventory
quantities?
Chapter 6 Review
What are the unique features of the income
statement for a merchandising company under
a periodic inventory system?
Explain the basis of accounting for inventories
and apply the inventory cost flow methods-FIFO, LIFO, weighted-average--under a periodic
inventory system.
Compare the financial statement and tax
effects of each of the inventory cost flow
assumptions-- FIFO, LIFO, weighted-average.
Chapter 6 Review
What is the lower of cost or market basis of
accounting for inventories?
What is the inventory turnover ratio? How is it
computed?
What is the LIFO reserve? Explain its
importance for comparing results of different
companies.
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